Directors, Insolvency and Personal Liability

CORPORATE / COMMERCIAL

Directors, Insolvency and Personal Liability

Knowing When to Stop: Ciara Seymour discusses the legal implications for directors of companies in financial difficulties.

Directors, Insolvency and Personal Liability

The recent case of Rubin v Gunner (2004) has highlighted the personal risks
for directors in allowing a company to continue trading when there is no reasonable prospect of avoiding insolvency. Whilst the case is yet unreported, the court held that the directors were wrong in their view that the company had reasonable prospects and were therefore exposed to a number of serious consequences including personal liability for the company's debts.

Directors may find themselves subject to the following consequences as a result of actions taken in the period before a company becomes subject to an insolvency procedure (such as liquidation or receivership):

• Disqualification Order - this may be made against a director and will declare
  that he is unfit to be concerned in the management of a company. During the time such an order is in force, the director may not be a director or involved in the promotion, creation or management of a company.
• Misfeasance or Breach of Duty - a director or person involved in the management of a company may have an order made against him requiring him to pay amounts to compensate the company for losses arising from his breach of fiduciary duty or misfeasance.
• Fraudulent Trading - a director who is knowingly a party to the carrying on of a business with the intent to defraud creditors or for any fraudulent purposes commits a criminal offence and, if the company goes into liquidation, may also be liable to make a contribution to the company's assets.
• Wrongful Trading - a director who allows a company to continue trading when there is no reasonable prospect that it will avoid going into insolvent liquidation may be required to contribute to the company's assets.

Avoiding Liability

Of all the liabilities set out above, wrongful trading is likely to be the most worrying problem for a director. As was made clear in the Rubin v Gunner judgement, a director's primary duty in an insolvency situation is not to act in the best interests of the company but to consider the interests of the company's creditors. Accordingly, a court will not make an order for wrongful trading if, knowing there was no reasonable prospect that the company would avoid going into insolvent liquidation, a director took every step with a view to minimising the potential loss to the company's creditors.

When deciding whether to make an order for wrongful trading the court will take into account factors such as the size of the business and the director's function and position. There are also a number of steps which can be taken by a director to reduce the possibility of being found liable for wrongful trading, for example:

• it is crucial that regular board meetings are called and that commercial decisions of directors are reported in full in the minutes;
• directors must ensure that they have up to date financial information at all times and should not have to wait for a creditor's claim or a winding up petition to alert them to problems. In particular, directors should be careful to monitor compliance with financial covenants contained in any arrangements with lenders; and
• as soon as a director is aware that there is no reasonable prospect of avoiding insolvent liquidation or fears that this is the case, he must raise the problem with the rest of the board with a view to taking immediate independent financial advice. Further credit should almost certainly not be incurred pending such advice.

Caution

To avoid unlawful trading, directors may have to face reality and cease trading. As the relevant time is not defined, it can be difficult to judge when to make this decision - the court will look at all the relevant circumstances. Companies can cease to trade without resorting to one of the insolvency procedures if the company is solvent and can pay off its debts. However, if this is not the case, the directors must instigate one of the forms of insolvency procedures (such as creditors' voluntary liquidation or administration) in order to protect the company's creditors (and themselves from personal liability). Directors unsure of what to do in such a situation should seek early professional advice rather than face the consequences at a later stage.

Ciara Seymour is an Associate in the firm's Corporate Department advising on general corporate, commercial and banking issues. Ciara can be contacted at ciara.seymour@lestrangeandbrett.com.

Quote: personal liability for the company's debts